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Struggling to Rebalance

Individual investors don’t like to rebalance. According to Congressional testimony given by Dallas Salisbury, CEO of the Employee Benefits Research Institute and one of the nation’s leading experts on retirement and savings, more than 3/4 of all 401 (k) holders never make a change to their asset allocation or rebalance. Not once.

Work goes into setting your asset allocation and designing a portfolio that fits your risk tolerance. If that erodes as winners grow and the slow-pokes shrink, it’s certain that your final portfolio won’t look much like your design over time.

The theory behind diversifying our holdings is that it will help to minimize the risk that we’ll suffer a huge loss. A failure to rebalance reduces a lot of the value of that insurance plan. Rebalancing can also force you to buy an asset that has taken a beating but might be poised for a comeback (like stocks in late 2008.) In a recent story in the Dallas Morning News Jerry Miccolis, chief investment officer at Brinton Eaton Wealth Advisors and co-author of Asset Allocation for Dummies acknowledges that rebalancing isn’t easy. “It’s going to seem counterintuitive – selling the winners and buying the laggards, but that’s going to make you finish the game ahead of everybody else,” he says.

So while studies of active investors trading patterns have shown a tendency to sell our winners and hang onto our losers, when it comes to portfolio rebalancing, we do just the opposite. We don’t know that this year’s winner will have another good year in 2011, but that’s often the bet we end up placing.

Vanguard has published a number of studies on rebalancing. In one from earlier this year, the firm’s researchers tested how a portfolio that started out 60% stock and 40% bonds in 1926 would have performed between that year and 2009. They looked it how it would have evolved if it had never been rebalanced during that 83 year stretch. Then they calculated how it would have performed if it had been rebalanced every single month.

The portfolio that was never reset actually had a higher average annual return — 9.1% compared to 8.5% for the one that was reset each month. But it also had wide swings in its holdings. At their low, stocks representing 36% of the total portfolio. At their high, 99%. In its final year the fund left entirely alone had 98% of its assets in equities. The rebalanced one had 61%.

For those convinced rebalancing makes sense, there are two primary questions: how often and how much will it cost?

Rebalancing monthly doesn’t seem to get much better results than doing so annually. Vanguard’s rule of thumb for broadly diversified stock and bond fund portfolios: rebalance once every 6 months or once every 12 months any holdings that have changed at least 5%.

Realigning your holdings less often saves on costs, but Morningstar also offers some other tips on how to minimize the bite.

First, use new money to rebalance. That minimizes the need to sell winners and the taxes on those gains.

If you must sell winners do so first in your tax-deferred accounts, like your 401(k).

Last, if you have investment income or the capital gains distributed by your mutual funds deposited into a money market account, you can then redeploy that to buy up what you need more of.

What Type of Investor Are You?

Understanding your investing profile to achieve your financial goals starts with a few simple questions. The Investor Questionnaire, by Folio Investing, will help you understand your investment time horizon, investor profile and level of risk.